If a principal residence is considered the ultimate personal tax shelter for some, then the vacation home is fast approaching a close second for many more.The recent run-up in the market value - and popularity - of second homes has helped solidify their place as a sound investment. The tax advantages make it even more worthwhile: mortgage and real estate tax deductions, rental exclusions and expense offsets on an annual basis, followed by ultimate disposition at primarily capital gains rates - or better, now that the rules are more clear for use of the personal residence exclusion and like-kind exchange deferral, singularly or in tandem.
While the 2004 American Jobs Creation Act recently put some brakes on the use of like-kind exchange treatment as a quick sidestep before taking the homesale exclusion, opportunities on the disposition side of vacation home ownership remain for those with the patience and flexibility to juggle the ownership and use rules properly.
Homesale basics
An individual may exclude from income up to $250,000 of gain ($500,000 on a joint return in most situations) realized on the sale or exchange of a principal residence. Ownership and use tests must be met and the exclusion may not be used more frequently than once every two years.
Gain may only be excluded if, during the five-year period that ends on the date of the sale or exchange, the individual owned and used the property as a principal residence for periods aggregating two years or more. The ownership and use tests may be met during non-concurrent periods. Military and foreign service personnel who are called to active duty away from home may elect to suspend the five-year test period.
Pro-rata reduced exclusion is available when the primary reason for sale of the home is due to a change in place of employment, health reasons or unforeseen circumstances.
Jobs Act revision
When an individual acquires a principal residence in a like-kind exchange, the 2004 American Jobs Creation Act now requires that the individual own the property for at least five years in order to have the homesale gain rules apply. Formerly, if the principal residence was acquired in a like-kind exchange, the individual only needed to own the property for two years before the exclusion provision generally became available.
Only two years' use as a principal residence, however, continues to apply for entitlement to the homesale exclusion on property acquired in a like-kind exchange. As a result, one "best case" situation under current law is to rent the exchange property for three years and then use it as a principal residence for the last two years before sale.
Caution: While the assumption is that a pro-rata benefit will be granted for reasons of change of employment, health or unforeseen circumstances before expiration of the two-year period, Internal Revenue Service guidance on that issue has yet to be put forth. Of course, if the taxpayer plans on using their home as a principal residence, but never starts to get the opportunity to do so, no pro-rata exclusion would then be available. Alternatives in that case include doing another like-kind exchange, or biting the bullet and recognizing capital gain. In the case of death, a stepped-up tax basis continues to be available under the current transfer tax system.
Vacation home as principal residence
Different strategies may apply depending upon the use of the vacation home and the tolerance of the taxpayer to moving.
For those retirees who can see their moving into their current vacation home as a principal residence for at least a few years (before they need to be geographically closer to children or medical facilities, etc.), significant tax savings are possible. At a maximum capital gains rate of 15 percent, sheltering $500,000 of gain under the homesale exclusion amounts to a $75,000 tax savings for a temporary lifestyle that may be part of a couple's retirement dream anyway.
As long as the couple makes their vacation home their principal home for two years, they can exclude up to $500,000 in gain if they then sell and move on. They can even sell earlier and get a pro-rata exclusion if their health changes or some other emergency arises.
Vacation home as like-kind property
Those who cannot move to the vacation home to make it their principal residence might consider having the vacation home in effect move to them by doing a like-kind exchange. Although requiring some fees to facilitate, most like-kind deals of this sort need a qualified intermediary to convert cash sales on either end of the transaction into an exchange. The usual scenario here is to convert the vacation home to rental property (if it is not already being rented out), then exchange it for a rental home for equal or greater value in the taxpayer's current neighborhood or where they want to retire to soon. The taxpayers then move into their new place after a year or two, use it as a principal residence until the balance of the 2004 Jobs Act five-year ownership period expires, after which they sell it under the principal residence gain exclusion (except for recaptured depreciation).
To qualify for treatment under Code Sec. 1031, three requirements must be satisfied: the transaction must be an exchange; the exchange must involve like-kind properties; and both the properties transferred and the properties received must be held either for productive use in a trade or business or for investment.
One trap in executing a like-kind exchange plan is to make certain that both properties are considered business or investment property at the time of the exchange. The intent of the taxpayer is important; case law generally tests intent under a facts and circumstances analysis. A taxpayer's intent to hold property for investment is determined as of the time of the exchange.
Renting for only a few months on both sides of the exchange generally won't pass that test unless the taxpayer can prove unanticipated events. Having rented the former vacation home for most of the "peak season," however, might qualify. Renting to friends probably will make it more difficult to pass the test.
Unfortunately, there appears to be no safe-harbor bright-line period for renting from which business purpose is unquestioned. Intent to eventually sell under the homesale exclusion, while not fatal, might be damaging in a close case. A full peak season under the vacation home side of the exchange may be safe, while having a tenant sign a year's lease on the other side of the exchange likely shows adequate business purpose.
Office at home
If a vacation home owner is going into semi-retirement by planning to work out of her home, the use of a vacation home as a residence in which an office at home exists may help increase tax benefits, especially if the homeowner anticipates eventually realizing more than the maximum excluded homesale gain. Rev. Proc. 2005-14, which deals with the use of part of a home as a home office, confirms that a property may qualify for both the homesale exclusion and like-kind exchange treatment.
For like-kind treatment, however, Rev. Proc 2005-14 requires not only that the vacation home be used as a home office, but that the taxpayer also set up a home office in the property eventually being exchanged after the vacation home is vacated.
Under Rev. Proc. 2005-14, if the home office is physically part of the residence, the entire property still qualifies for the homesale exclusion. If the home office is in a separate structure from the main house, the homesale exclusion does not apply to that pro-rata part of the market value, unless it was used as a principal residence for two of the previous five years.
While the homesale exclusion cannot shelter any gain attributable to the recapture of depreciation deductions taken after May 7, 1997, the like-kind exchange provisions can defer that gain. However, under the revenue procedure, cash-out "boot" is tax free to the extent that it does not exceed the amount of excluded homesale gain attributable to the relinquished business property.
Conclusion
Vacation-home ownership generally requires a long-term financial commitment. Banking on the tax benefits can sometimes help vacation homeowners get through the initial years, during which money is generally the tightest. As the home increases in value, eventually paying as little tax as possible on that increase becomes a significant objective.
Tax laws change and planning to hold a vacation home for many years makes tax planning on its ultimate disposition difficult. Especially for those with relatively short-range plans to sell their vacation home, however, use of the homesale exclusion or the like-kind exchange provisions, or both, can be a lucrative consideration.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a WoltersKluwer company.
